[This post on portfolio construction contains links to other articles on this website, as well as to other websites that I used to cite my examples. If you haven’t already, please take a moment to review the website disclosure statement here.]
Investing, Risk, & You
Let the good times roll!
Not only a great song but also an exceptional investment strategy! When the markets are up, don’t get greedy; invest as usual. When the markets are down, don’t panic; continue to invest. Neither scenario matters to you; you just let the good times roll!
Sounds pretty good, doesn’t it? Investing should be done like this, stress-free.
Now, the easiest way to let the good times roll is through dollar-cost averaging. Then, all you need to do is wait; the markets will take care of the rest!
Not familiar with dollar-cost averaging? That’s finance jargon for buying mutual funds on a consistent schedule for the same dollar amount, regardless of the news. Through this method, you too can become wealthy.
Are you going to become rich overnight? No, you aren’t. But this is a tried and trued strategy, particularly amongst followers of index funds and the Boglehead community.
Want proof? Well, historically, $500 invested each month, earning 10% on average, would have made you a millionaire in just under 30 years, all accomplished by letting the good times roll!
Crazy, I know. And while the past is no guarantee of the future, the preceding example illustrates the power of dollar-cost averaging and sticking to a plan.
However, do you know what is not a great investment strategy? Letting the good times roll until they aren’t, then selling your investments as the markets crash!
If this sounds like you, then as the title suggests: You’re Investing Wrong!
Your portfolio construction should look like you!
When you look at your portfolio, your risk tolerance should be evident within your investments; this means risk-takers should hold more stocks, while those more hesitant to fluctuations should hold fewer!
Now, no one can decide risk for you because it is your specific tolerance for fluctuations in the value of your portfolio.
Thus, if the idea of a market downturn gives you an upset stomach and the desire to sell, do not reach for Peptobismal. Instead, it is time to have an honest conversation with yourself around risk and reward.
Why do I say this?
Because, while previously working as an advisor at one of the largest financial firms, I would meet regularly with new clients who had just sold after the downturn and were now looking for help in picking up the pieces.
In almost every meeting, a pattern emerged: The individuals had been over-exposed to risk given their specific tolerance for it and personal preferences.
My takeaway was this: It is excellent to hold investments during the upside; everyone can. But if you cannot watch the downturn without intervening, you cannot let the good times roll! Instead, your portfolio needs to be rebuilt so that it reflects you!
So I challenge you, can you handle the subsequent correction or crash that is yet to come? If not, read on!
Diversification is essential
The easiest way to fix having too much risk in your portfolio is through diversification, which is why I advocate for the use of funds!
Funds do a great job of spreading risk for you by investing in a group of securities, whether they be stocks or bonds, or both. By increasing your underlying holdings, the chances of loss are reduced since you are no longer dependent upon the success or failure of one investment.
Generally, investors should strive to keep their portfolio in two main asset categories: Stocks & Bonds. If you think of stocks and bonds as a football team, stocks are your offensive team; bonds are your defensive team. The reasoning for this is that stocks are used to grow your portfolio, while bonds are used to preserve it.
Now, ordinarily, the older you become, the greater the exposure to bonds you will desire. The reasoning for increased bond exposure is to provide stability since, as you age, the likelihood of withdrawing your money increases. Thus you have less time for your investments to recover from a loss, so you will want to protect them. After all, who wants to live forever or never to use the money they saved?
Queen and The Cars in the same article; I wonder if I can fit any other classic rock references into this post…
Anyway, no two people are identical, so invest according to your risk tolerance.
But Olaf, that is easier said than done! How does one determine their risk tolerance?
I’m glad you asked.
Determining risk tolerance
Above, you will see a chart that Fidelity Investments assembled, which shows portfolio returns for various investor types with different risk profiles. The four asset categories represent the average index performance of domestic stocks, foreign stocks, government bonds, and short-term (cash equivalent) investments from 1927-2019.
Remember: Risk is your ability to tolerate fluctuations in the value of your money in the hope of reward.
While I have previously covered stocks – foreign and domestic – and bonds in Not Your Grandma’s Guide to Stocks & Bonds, I have not yet covered short-term cash-equivalent investments. As a brief synopsis, the most common cash equivalents are money markets, CDs, and high-interest saving accounts. These short-term investments will not lose value due to a market crash, and they act as an anchor for your portfolio [a post on this topic is coming soon]. However, cash equivalents generally lose value due to inflation over time, as a dollar today is not worth the same as a dollar in 1970!
Thus, you are now ready to dial in your portfolio’s risk tolerance using the historical data above as you understand the four different asset classes and how risk and reward are intertwined. Importantly, this is not a static one-time choice; you will move between risk profiles during your lifetime. Life is not stationary, after all!
Generally, most people progress from right to left on the above chart as they age, though some people will never move as far left as others. If you are unsure about where your risk tolerance falls after looking at this diagram, create a five-year plan that maps out where you want to be!
Once you have evaluated what this period will look like, you can compare historical gains or losses using the teal and orange return bars that illustrate five-year periods in the bar graphs above.
If a downward fluctuation in a risk profile makes you uncomfortable enough that you are likely to sell your investments, then this risk profile is not for you!
During this evaluation of your risk tolerance, it is essential to be honest with yourself. While most investors would benefit by investing in a stock-heavy portfolio, which is not touched until retirement, my real-world experience shows that this is not probable. To be human is to have emotions, and some of us are more equipped than others to handle dramatic changes in our net worth. For those with time on their side and a stomach that can handle fluctuations, the chances of losing money in the US stock market decrease to zero, historically, over twenty-year periods and longer.
A note on foreign stock exposure
While this section deserves a post of its own, I will quickly recap my thoughts here briefly.
A later post will come, though I am unsure when. [International stocks post is now live]
Many people wonder if it is necessary to venture outside of domestic stocks. My answer is yes, it is essential. The United States is not the only shop in town, and you are setting yourself up for failure if you ignore the rest of the world. Time and time again, research has shown that holding international stocks leads to similar returns and lower fluctuations in portfolio value; this is the equivalent of having your cake and being able to eat it, too. Talk about a stairway to heaven!
Sorry, I had to fit in one more rock reference; thanks, Led Zeppelin.
Anyway, the risk profiles above assume that the stock component of your portfolio will be allocated 70/30 to domestic/foreign funds. This means that if you choose to have 50% invested in stocks and 50% in bonds, that your stock funds will be 35% domestic and 15% foreign.
50% stocks * 70% domestic = 35% domestic stocks
50% stocks * 30% foreign = 15% foreign stocks
Now, holding 30% within international funds is not the requirement for your portfolio. Still, Vanguard’s research has shown that anywhere between 20% to 40% invested in foreign stocks is sufficient to lower risk while maintaining returns.
Remember how I said I love funds because they diversify your investments? Well, adding international stocks only increases the diversification benefits for your portfolio without sacrificing returns. So, choose what makes you the most comfortable for international and let the good times roll!
Added on 10/12/21: My own research has shown that holding international stocks has lowered returns over the past 35 years, but there is no way to predict if this will hold for the next 35 years. Thus, I would still advocate holding international stocks as we could enter a period where international markets outpace our domestic ones.
Tying it all together
So, we now know your risk tolerance and how much you will hold to stocks, bonds, and short-term investments. Now begins the construction or rebuilding phase to reach the determined amounts!
The easiest way to build your portfolio is by using funds, and if you are unsure how to choose the proper funds, now is a great time to read Choosing the Best Index Fund. Once you have your funds selected, all you have to do is exchange your investments to reach your new desired risk level. Then rebalance your portfolio twice a year or whenever your investments drift by more than 5%. Otherwise, let the good times roll and reassess your plan whenever a significant life event occurs.
Remember, your life is not static, and your investment strategy should not be either.
Now that is it! Get out there and make sure your investments match you. I thank you for reading today’s post, and as always, have a great day! Let me know in the comments below how much stock to bond exposure you use and if you have ever sold during a market downturn! Investing and risk will always be different from individual to individual, so I would love to hear from you.
What are the steps in portfolio construction?
The first step in portfolio construction is assessing your risk tolerance. Once you have determined how much risk you are willing to take in pursuit of gains, you can move onto selected individual holdings or funds in three areas at a minimum: domestic stocks, foreign stocks, and bonds. Advanced investors may choose to tilt their portfolio towards value, growth, large cap, small cap, or real estate.
What is the goal of portfolio construction?
The goal of portfolio construction is to optimize the risks undertaken in the pursuit of rewards. If one is highly risk averse, the goal is to protect their assets. If one is willing to take substantial risk, they can pursue more substantial returns.
Mile High Finance Guy
finance demystified, one mountain at a time